The euro in troubled waters

The fate of the monetary union at the beginning of the summer of 2012 was far from certain. The Greek crisis had exposed much more than just Greece’s structural problems. It had also exposed the incomplete architecture of the euro, including the absence of an effective crisis management mechanism. All of a sudden access to financial markets became much more important than previously thought, as market participants realized that there was no automatic bailout mechanism in place. Countries that appeared to be lacking fiscal discipline came in for considerable battering by their peers, as politicians responded to the lack of appetite on the part of electorates for bailing out other countries. Markets had clearly underestimated the deep distaste of public opinion in Germany towards fiscal profligacy and the extent to which it could influence the German government’s willingness to take part in the Greek bailout.

Moreover, the disconnect between monetary policy, which was conducted at the Eurozone level, and fiscal policy, which remained in the hands of member states, made any country with a high sovereign debt vulnerable to a bank run, since the provision of bank liquidity was the ECB’s prerogative. Cash in hand became much safer than bank deposits, especially in countries at risk of leaving the euro. Greek depositors demonstrated this abundantly: deposits in Greek banks declined from almost €280 billion before the crisis to just over €150 billion at the peak of the crisis in 2015 (see Figure 5.1). This was another design peculiarity to the euro area that was beginning to create new strains.

With deposits fleeing Greece’s banks, the ECB’s function as lender of last resort was itself becoming another source of vulnerability. Like any other central bank, the ECB could supply liquidity to Greek banks only as long as these banks were solvent. The bank’s solvency was dependent on the sovereign’s solvency, however, not least because Greek banks were holding a disproportionate amount of Greek government bonds (GGBs) – a pattern repeated in most other euro area countries, including heavily indebted Italy.